Gator Fabrics Inc. currently has zero debt. It is a zero growth company, and it
ID: 2670343 • Letter: G
Question
Gator Fabrics Inc. currently has zero debt. It is a zero growth company, and it has the data shown below. Now the company is considering using some debt, moving to the new debt/assets ratio indicated below. The money raised would be used to repurchase stock at the current price. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, i.e., what is WACC Old- WACC NEW?New Debt/Assets 35%
Orig cost of equity, rs 10.0%
New Equity/Assets 65%
New cost of equity = rs 11.0%
Interest rate new = rd 7.0%
Tax rate 40%
Explanation / Answer
The company is an all equity firm when the company has zero debt.
Therefore, the weight of equity = 100% or 1.00
Cost of equity = 10.%
WACC = Weight of equity * Cost of equity
= 1.00 * 0.10
= 0.10 or 10%
When the company is an all equity firm, the value of WACC is equal to the cost of equity
Computing the WACC after raising the new debt.
WACC = Weight of debt * Cost of debt * ( 1 - Tax rate) + Weight of equity * Cost of equity
= 0.35 * 0.07 * (1 - 0.4) + 0.65 * 0.11
= 0.0147 + 0.0715
= 0.0862 or 8.62%
Difference in WACC is
WACC old - WACC new = 0.10 - 0.0862
= 0.0138 or 1.38%
Thus, change in WACC = 1.38 %
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